My most recent books are the Leader's Guide to Radical Management (2010), The Leader's Guide to Storytelling (2nd ed, 2011) and The Secret Language of Leadership (2007). I consult with organizations around the world on leadership, innovation, management and business narrative. At the World Bank, I held many management positions, including director of knowledge management (1996-2000). I am currently a director of the Scrum Alliance, an Amazon Affiliate and a fellow of the Lean Software Society. You can follow me on Twitter at @stevedenning. My website is at www.stevedenning.com.

The same thing happens in economics. Take a recent study that set out to shed light on the role of Chinese businesses vis-à-vis American consumers. Galina Hale and Bart Hobijn, two economists from the Federal Reserve Bank of San Francisco, did a study showing that only 2.7% of U.S. consumer purchases have the “Made in China” label. Moreover, only 1.2% actually reflects the cost of the imported goods. Thus, on average, of every dollar spent on an item labeled “Made in China,” 55 cents go for services produced in the United States. So the study trumpets the finding that China has only a tiny sliver of the U.S. economy.

So no problem, right?

Well, not exactly. The tiny sliver happens to be the sliver that matters. What economists miss is what is happening behind the numbers of dollars in the real economy of people.

How whole industries disappear

Take the story of Dell Computer [DELL] and its Taiwanese electronics manufacturer. The story is told in the brilliant bookby Clayton Christensen, Jerome Grossman and Jason Hwang, The Innovator’s Prescription:

ASUSTeK started out making the simple circuit boards within a Dell computer. Then ASUSTeK came to Dell with an interesting value proposition: “We’ve been doing a good job making these little boards. Why don’t you let us make the motherboard for you? Circuit manufacturing isn’t your core competence anyway and we could do it for 20% less.”

Dell accepted the proposal because from a perspective of making money, it made sense: Dell’s revenues were unaffected and its profits improved significantly. On successive occasions, ASUSTeK came back and took over the motherboard, the assembly of the computer, the management of the supply chain and the design of the computer. In each case Dell accepted the proposal because from a perspective of making money, it made sense: Dell’s revenues were unaffected and its profits improved significantly. However, the next time ASUSTeK came back, it wasn’t to talk to Dell. It was to talk to Best Buy and other retailers to tell them that they could offer them their own brand or any brand PC for 20% lower cost. As The Innovator’s Prescription concludes:

Bingo. One company gone, another has taken its place. There’s no stupidity in the story. The managers in both companies did exactly what business school professors and the best management consultants would tell them to do—improve profitability by focus on on those activities that are profitable and by getting out of activities that are less profitable.

Amazon couldn’t make a Kindle here if it wanted to

Decades of outsourcing manufacturing have left U.S. industry without the means to invent the next generation of high-tech products that are key to rebuilding its economy, as noted by Gary Pisano and Willy Shih in a classic article, “Restoring American Competitiveness” (Harvard Business Review, July-August 2009)

The U.S. has lost or is on the verge of losing its ability to develop and manufacture a slew of high-tech products. Amazon’s Kindle 2 couldn’t be made in the U.S., even if Amazon wanted to:

The flex circuit connectors are made in China because the US supplier base migrated to Asia.

The electrophoretic display is made in Taiwan because the expertise developed from producting flat-panel LCDs migrated to Asia with semiconductor manufacturing.

The highly polished injection-molded case is made in China because the U.S. supplier base eroded as the manufacture of toys, consumer electronics and computers migrated to China.

The wireless card is made in South Korea because that country became a center for making mobile phone components and handsets.

The controller board is made in China because U.S. companies long ago transferred manufacture of printed circuit boards to Asia.

The Lithium polymer battery is made in China because battery development and manufacturing migrated to China along with the development and manufacture of consumer electronics and notebook computers.

An exception is Apple [AAPL], which “has been able to preserve a first-rate design capability in the States so far by remaining deeply involved in the selection of components, in industrial design, in software development, and in the articulation of the concept of its products and how they address users’ needs.”

A chain reaction of decline

Pisano and Shih continue:

“So the decline of manufacturing in a region sets off a chain reaction. Once manufacturing is outsourced, process-engineering expertise can’t be maintained, since it depends on daily interactions with manufacturing. Without process-engineering capabilities, companies find it increasingly difficult to conduct advanced research on next-generation process technologies. Without the ability to develop such new processes, they find they can no longer develop new products. In the long term, then, an economy that lacks an infrastructure for advanced process engineering and manufacturing will lose its ability to innovate.”

The lithium battery for GM’s [GM] Chevy Volt is being manufactured in South Korea. Making it in the U.S. wasn’t feasible: rechargeable battery manufacturing left the US long ago.

Some efforts are being made to resurrect rechargeable battery manufacture in the U.S., such as the GE-backed [GE] A123Systems, but it’s difficult to go it alone when much of the expertise is now in Asia.

In the same way that cost accounting and short-term corporate profits don’t reflect the true health of corporations, the economists’ reckoning of the impact of outsourcing production overseas misses the point. Americans are left with shipping the goods, selling the goods, marketing the goods. But the country is no longer to compete in the key task of actually making the goods.

Pisano and Shih have a frighteningly long list of industries of industries that are “already lost” to the USA:

What’s to be done?

With such a complex societal problem, it’s hard not to start from Albert Einstein’s insight: “The significant problems that we have cannot be solved at the same level of thinking with which we created them.” Many actors will have to play a role.

Company leaders: Business leaders need to recommit themselves to continuous innovation and the values and practices that are necessary to accomplish that. i.e radical management. As Pisano and Shih write: “Whether you’re the US firm IBM [IBM] with a major research laboratory in Switzerland or the Swiss company Novartis [NYSE:NVS] operating in the biotech commons in the Boston area, sacrificing such a commons for short-term cost benefits is a risky proposition.”

Investors: Investors need to realize that the companies of the future are those that practice continuous innovation as Apple [AAPL], Amazon [AMZN] and Salesforce [CRM], as compared to companies practicing traditional management, such Wal-Mart [WMT], Cisco [CSCO] OR GE [GE]. Investors need to realize that short-term financial gains are ephemeral: the companies that will generate real value are those that do what is necessary to continuously innovate.

Government: Government has a role to play in protecting and promoting fields of expertise or what Pisano and Shih call “the industrial commons”. Thus: “Government-sponsored endeavors that have made a huge difference in the past three decades include DARPA’s VLSI chip development program and Strategic Computing Initiative; the DOD’s and NASA’s support of supercomputers and of NSFNET (an important contributor to the Internet); and the DOD’s support of the Global Positioning System, to mention a handful.”

Politicians: At a time of poisonously divisive political debate, in which candidates recite anti-government mantras and call for “getting government out of the way of the private sector”, it is time for serious politicians to step up and examine which parts of the private sector are fostering, and which parts are destroying, the economy of the country. They must stop embodying e.e. cummings definition of a politician as “an ass upon which everyone has sat except a man.”

Economists: Economists need to realize that merely adding up the numbers is not enough. They have to look at the meaning behind the numbers. When they trumpet their finding that “Chinese goods are only 1% of the U.S. economy”, it’s akin to saying “we kept the house but gave away the keys.”

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PLEASE get your facts correct. It is not Flexconn, it is FOXCONN http://www.businessweek.com/magazine/content/10_24/b4182035750226.htm Apple plays the game the same as Dell and HP, only you have chosen to either overlook those facts or it was an honest mistake.

While you are at it, you should call out the tax structure and the legal system that handcuffs you every step of the way in developing a business, as compared to other countries, especially China. Too bad the Chinese haven’t caught up to and surpassed American standards in those fields as well….probably the secret to their success…

Steve, superb article. The only thing that I would add is that the design expertise inexorably follows the manufacturing expertise and the R&D expertise follows the design. The rationale that “The US leads in the brain work, we let the third world put it together” is whistling past the graveyard. one day, we will no longer have the vaunted R&D, either.

Although it’s not highly emphasized in the article, what I find most noteworthy is the idea that exporting the manufacturing work erodes the knowledge and experience that makes innovations, improvements and future competitiveness possible.

In the long run, losing the process engineering knowledge seems more important than any near-term loss of jobs, profits, etc.

US businesses are not just moving the work; they’re losing the know-how. We have reached or will soon reach the point where domestic manufacturing will never recapture the business, even if we were to regain parity in things like labor costs.

So to me, it’s this side-effect–the knowledge transfer–that’s most important and threatening to our domestic economy.

It’s FOXXCOM (a Taiwanese company with sweatshop manufacturing in China), NOT “Flexcom”. There is no such company.

The PERTINENT comment here is that Apple HASN’T MADE ANYTHING since 1979 when they OUT SOURCED the Apple IIe to a Canadian “Jobber”. (see my detailed comment, far below). Apple “the American Hardware Company” is a SHAM!! And the HACK Media helps perpetuate this sham! Apple makes NOTHING!

And Apple steals product ideas from others – The iPhone was a rip off of the LG Prada, shown a full year before at CeBIT Germany. iPod ripped off the Rio, the iPAD ripped off a 11″ Tablet Gateway had in 2002, which had handwriting recognition (I reviewed it).

By your apparent definition, headlinestoo, all American high-tech companies make “NOTHING” since all of them use Asian subcontractors to manufacture their products. No need to single out Apple. By the way, unlike many other companies, at least Apple does its own *real*engineering, design, and R&D in the U.S…